Choose the broadest available whole market diversification

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Choose the broadest available whole market diversification

Another risk reduction objective should be to achieve the broadest possible securities market diversification within your overall portfolio holdings. Whenever several low cost investment funds are available, I suggest choosing the fund with the broadest market coverage. This reflects a preference for owning the entire market. Such funds are often named “whole market,” “total market,” or “multi-cap” funds.

Funds that invest in company size-based subsets of the market are usually known as “large-cap” versus “mid-cap” versus “small-cap” stock mutual funds or stock ETFs. Overall, it is important to hold all different sized equities roughly in proportion to the market capitalizations of these company size groupings.

The investment research literature indicates that investors in funds with portfolios that are skewed by company size will experience greater volatility. Over time, as demand shifts from large-to-small or small-to-large capitalization companies, these portfolio are more variable compared to the returns of the overall market.

Thirty years ago, research indicated that small capitalization stocks delivered excess returns that were disproportionately high even in comparison to the presumably greater risks of smaller firms. Research that is more recent suggests that this argument is much less conclusive today.

In addition, there are also many more mid-cap and small-cap investment funds, and vastly more assets are deployed to exploit this supposed small-cap company investment advantage. Such is the nature of investing. Apparent advantages often disappear as more assets move in to exploit suspected advantages.

Other more hidden problems might arise, when investing in company size-based market subsets rather than in the overall stock market. Some stock market indexes are mechanically defined, and changes in the list of company constituents of an index may be anticipated. As companies are added or are withdrawn from the company size sub-indexes, some market participants may attempt to profit by anticipate these sub-index changes and by accumulating long and short trading positions in advance.

When company size-based benchmark indexes change, the index funds that track those benchmark indexes must buy or sell to reflect these changes in their portfolio holdings. Changes in demand for particular stocks can create a potential advantage to traders who have anticipated these changes. This “front-running” could be detrimental to the performance of these company size-based  index investment funds. Note, however, that adjustments have been made in the past decade to make this type of index change front-running much more difficult for traders.

Whether or not this is a potential problem when one chooses funds based on sub-indexes of the market that are skewed by company size, it is not a problem when one invests in index funds that span the entire market. When an investor holds low cost, passively managed index investment funds that represent all sizes of companies, it will not matter if individual stock prices change somewhat as companies are added or subtracted within subsets of the overall market.

Price fluctuations due to sub-index membership changes will be neutralized overall. The total market index investor holds all the stocks, including those that might increase modestly in value by being added to a sub-index and those that might decline slightly in value by being removed from a sub-index. By owning the whole market, these potential hidden cost problems related to redefining sub-indexes just disappear.

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